In the financial industry, and in particular, the derivative instrument markets, delta is defined as the ratio of a change in the price of an underlying instrument, e.g. a commodity, equity, security, contract, or other asset or combination thereof, referred to as an “underlier” or “underlying asset,” to the change in the price of a derivative instrument, e.g. an options contract, based thereon, such as the ratio of a change in the price of a futures contract to the change in the price of an option contract on that futures contract. A portfolio comprising multiple instruments, derivative or otherwise, also referred to as “positions,” may be characterized by an overall delta based on the deltas of the portfolio's constituent instruments and the parameters thereof. In particular, the portfolio may be characterized as being “delta neutral” when the deltas of the various constituent instruments are offsetting, e.g. some positive and some negative such that the net delta is zero. When the delta of an instrument/position or a portfolio is positive, the position or portfolio may be characterized as being over-hedged and when the delta of an instrument/position or a portfolio is negative, the position or portfolio may be characterized as being under hedged. Either situation may be undesirable or otherwise sub-optimal depending upon the trader's trading strategy as the level of risk offset is either less than what the trader desired or is more than the trader needs, resulting in unnecessary and/or undesired risk and/or cost.
Delta hedging refers to an options strategy that aims to reduce, i.e. hedge, the risk associated with price movements in an underlying asset by offsetting long and short positions therein, i.e. purchases and sales. For example, a long call option position on a stock may be delta hedged by shorting the underlying stock. This strategy is based on the change in premium (the price of the option) caused by a change in the price of the underlying security. The change in premium for each basis-point change in the price of the underlying asset is the delta and the relationship between the two movements is the hedge ratio, i.e. the ratio, determined by an option's delta, of futures contracts to options on futures contracts required to establish a riskless position. For example, if a $1/barrel change in the underlying Oil futures price leads to a $0.25/barrel change in the options premium, the hedge ratio is four (four options for each futures contract).
To facilitate delta hedging, or other trading strategies where a trader wishes to manage the delta of their portfolio or otherwise hedge risk in their trading strategy, an Exchange, such as the Chicago Mercantile Exchange, may offer products or mechanisms to allow a trader to make trades which result in a desired delta specified by the trader. This resultant delta, for example, in combination with other positions in their portfolio, may result in an overall delta neutral portfolio or, alternatively, an overall desired delta value for the portfolio.
For example, the Exchange may offer, as a product or service, a “covered trade,” also referred to as a “delta neutral” trade, which is a spread that includes both the option contract, i.e. the derivative, and a futures contract, i.e. the underlier, entered as a single order for the covered option at a delta specified by the user, whereby the Exchange will calculate and provide/assign the appropriate quantity of futures contracts automatically to achieve the specified delta based on the quantity of option contracts specified in the order. For example: if the trader places an order to buy a covered call option or sell a covered put option, the Exchange will assign the trader with an order to sell one or more futures contracts; and if the trader places an order to buy a covered put option or sell a covered call option, the Exchange will assign the trader with an order to buy one or more futures contracts; etc. Note that another trader submitting the matching counter order will be assigned the counter position in the futures contracts as well.
The quantity of futures contracts is computed and the futures contracts are assigned, typically, at the time that the options order is matched with another order counter thereto. The number of futures contracts assigned is based on the quantity of options contracts filled and may be calculated as the quantity of options contracts filled multiplied by the desired delta. For example, if a trader places an order for a covered trade of 100 options at a delta of 0.30 and if the order completely matches with a counter order of the same quantity (for purposes of the discussion herein, the fact that the order “matches” implies that all of the other requisite parameters of the two orders are aligned), then the number of futures contracts assigned to the trade will be 30, i.e. 100×0.30. If the counter order is only for a quantity of 10, then the number of futures contracts assigned to the trade will be 3, i.e. 10×0.30, and the remaining quantity of 90 will remain on the order book “resting” and waiting for another counter order to be received which, at that time, will be assigned additional futures contracts depending upon the quantity filled.